The Barriers to Bottom Fishing

John Dizard, in today’s Financial Times, tells us why, despite the fact that a lot of fixed income paper is on offer at very cheap prices, no one seems to be stepping to the plate. And his explanation bodes ill for things turning around very soon.

The simple story is that even though the buys look compelling, most of the capital in the markets today isn’t in the hands of people acting on their own behalf but agents of various sorts, using other people’s money. And many, like hedge funds, use leverage.

So even if an asset is a screaming buy, these investors worry that they may get cheaper yet. That would pose two problem. First, they’d have to show a loss (remember, they mark to market) before the position eventually works out and shows a nice profit. Investors don’t like seeing negative or sub-par returns even in the best of times, and these are far from the best of times. Second, if they are using borrowed funds, they would face a margin call if the asset fell in price, which would force them to sell either that position (at a loss) or another one.

This line of thinking implies that the only people who can step forward and act as bottom fishers are people using their own capital, and the existing distressed bond funds (which presumable don’t use any or much leverage due to the volatility of their investments). But the amount of securities soon to be on offer is likely to considerably exceed the capacity of either of those two sources.

From the FT:

A good strategy for the months ahead is to identify forthcoming liquidations of credit securities baskets, do the value analysis in advance, and wait for the afflicted institutions to do the dumping.

I say fixed income because the cash flows can be more easily determined in advance than with value equities, and you can be paid to wait for the prices to come back – if you’re right.

Late last week, a credit investor friend of mine was looking at a list of $4bn (face value) of securities being offered by some large fund being liquidated, apparently in London. There were single-A floating rate home equity securities being offered at 37.5 and 20 cents in the dollar. That is, a so-far performing bond, rated at the same level as many banks, being offered with a coupon of 35 per cent.

Nobody was buying it.

Let’s say you liked the value of the underlying collateral. Even with a very high default rate, this bond could well be covered by its collateral.

However, cheap though it is, the problem is that it could get cheaper. So professional credit investors, most of whom depend on bank lines, could be required to mark it down. Then, in a margin-call event, they could be at risk of not meeting the call, which is what happened to the previous owner.

But never mind the banks. What about the nervous limited partners? This is the problem outlined in a 1997 paper, which I once again recommend for your reading list, by Andrei Shleifer and Robert Vishny, called The Limits of Arbitrage.

The two mathematically rigorous economists showed how, at the very moments that an arbitrageur using investors’ capital could find the most compelling values, investors would be likely to pull their money back.

Well, people, we are right now at the limits of arbitrage in the structured credit markets.

The can opener, in the form of speculative capital, that Bernanke & Co. assume will open up the credit markets, ain’t there or ain’t big enough. That’s why there weren’t any bids for that homeless paper.

However, if you are a “real money” person, you can do pretty well in these circumstances. Not every piece of dubious paper will be rescued when the politicians grab the wheel from the economists, but a lot will be.

At the prices that will be on offer, it looks as if you need to collect just a couple of years’ worth of coupons, let alone the principal, to make money.

We’re just a month or two away from even bigger forced liquidations.

Even with the Fed’s support, the banks don’t have the capital to be the buyer of last resort for everything. It’ll be raining soup, if you don’t mind taking a mark.